Record-low interest rates continue to create head winds for clearing firms, which traditionally have profited from the spreads earned from holding clients' cash.
Before the financial crisis, clearing firms profited handsomely from paying clients interest of 1% to 2% on cash in their accounts and either lending it or investing it at higher rates. But with the federal-funds-rate target at zero and annual yields on money market funds a slim 50 basis points, that profitable spread has disappeared for clearing firms and other financial institutions, including independent broker-dealers.
“Economic times are challenging, and interest rates have a lot to do with that,” said Sanjiv Mirchandani, president of National Financial Services LLC, Fidelity Investments' clearing arm. “Interest rates are like the force of gravity in the industry, for everybody — broker-dealers, clearing firms and clients. And the sentiment is that [the low-interest-rate environment] will continue for the foreseeable future.”
And that means potentially more consolidation for an already shrunken industry, as well as more effort by clearing firms to create compelling services for broker-dealer clients, analysts and executives said.
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“The margins have trimmed and you're seeing the effects of that play out right now,” said Craig Gordon, director of RBC Correspondent Services, which acquired Mesirow Financial Inc.'s clearing business this year.
Mesirow “just didn't have the scale to be in the business. Smaller firms are under pressure,” Mr. Gordon said.
Indeed, one of the fastest-growing clearing firms of the past 10 years, Penson Worldwide Inc., said at the end of May that it was leaving the U.S. clearing business and transferring most of its broker-dealer clients to a new group, Apex Clearing Solutions LLC.
The low-interest-rate environment was bad news for Penson, Mr. Gordon said. “With the revenue missing from the interest rate side, they didn't have enough,” he said. “Their model was built around low transaction charges and ticket costs. Their clients were paying some of the lowest charges in the industry. That makes it difficult for a business to survive, and it will be difficult for others who don't have scale.”
When asked about Mr. Gordon's assessment, a spokesman for Penson referred InvestmentNews to Apex, which had no comment.
“The clearing industry is changing rapidly,” said Alois Pirker, research director with Aite Group LLC. “Expectations for clearing firms have increased dramatically. They need to offer mobile applications and online services. Increasingly, broker-dealers are looking to clearing firms and saying, "I need this,' or, "I want that.'' The services are way beyond execution.”
Two types of firms that serve retail financial advisers have emerged. The first is a large operation tied to a network of retail brokers, such as RBC Correspondent Services, First Clearing LLC and Raymond James Correspondent Services.
The second is large organizations, such as Pershing LLC or National Financial, that have significant scale and market share.
Smaller players, such as Legent Clearing LLC, which was acquired at the end of last year by Cor Capital LLC, a private-equity firm, could struggle, as they lack scale and an affiliation with a large financial institution, Mr. Pirker noted.
“There are 16 clearing firms right now,” he said. “It will be 10 in a few years.”
Cor Capital has no intention of selling Legent, said Hugh Dunkerley, executive vice president of capital markets at Legent. Indeed, Legent is part of the private-equity investor's plan to expand in the financial services sector, he said.
“We're not in the flipping game,” Mr. Dunkerley said. “We're in the creating-value game.”
James Crowley, chief relationship officer at Pershing, believes consolidation is more likely among second-tier firms.
“I don't see any further consolidation among top-tier providers,” he said, “but it's more likely for some consolidation in the next tier of firms.”
Mr. Crowley added: “If there is an opportunity for consolidation among top-tier providers, it would be very much in line with strategic-growth opportunity or a very unique situation for firms.”
Meanwhile, clearing firms are continuing to add services for broker-dealers in an effort to win loyalty as well as build revenue. The business services often are technology solutions that would be costly for broker-dealers to create or buy from a third party.
Pershing, for example, will operate and maintain a broker-dealer's website that clients use. “We want to improve navigation and content for broker-dealers to leverage the technology we have built and broker-dealers can use,” Mr. Crowley said.
National Financial is offering an imaging system to 30 broker-dealer clients to use in their back offices to replace paper. “When we put that service in place, we charged for it, and customers saved money,” said Mr. Mirchandani. “That's how we improve our margins.”
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